The Ultimate Reality Check for Gold and Silver

A daunting array of stress-inducing catalysts has gripped investors by the throat, offering scarcely a moment to catch their collective breath.

Reality checkEven the most predictable of developments -- like the failure of the not-so-supercommittee to reach a deal on U.S. deficit reduction -- appeared to wield power over the schizophrenic whims of the market-directing, big-money players. And yet again, it's retail investors -- including Fools like us -- who get trampled by the resulting stampede for the exits.

United States debt trudged unrepentantly through the $15 trillion mark last week. The deficit-reduction circus on Capitol Hill confirms that elected officials still fail to grasp the enormousness of the stakes here, even as the nation's debt threatens to surpass gross domestic product (GDP) imminently. Although the commonly reported core inflation rate appears moderate at 2.1%, that number offers little solace to those struggling with gasoline prices that rose 28% over the past year, and food inflation at 4.7%. The average Thanksgiving meal will cost 13% more this year than last, which is something many will not be very thankful for. And if we needed one more reminder of the remaining challenges domestically, the Federal Reserve has obliged with a second round of stress tests with a Lehman-like event out of Europe at the core of the scenario.

Anyone caught up in the wishful excitement of Silvio Berlusconi's recent departure as Italy's prime minister soon discovered that crisis mode in Europe remains in full swing. Italy's 10-year bonds are yielding 6.8%, mounting pressures on Spain's debt remain in the crosshairs of a nervous bond market, and now borrowing costs for Belgium are leaping sharply higher.

Importantly, China's response to a deteriorating outlook for the global economy may include a massive $1.7 trillion stimulus program to eclipse the scale of its game-changing 2008 intervention. I believe China's prior round of stimulus spending resulted in the most overlooked story for investors in 2009, drawing an impenetrable line of baseline demand beneath the outlooks for multiple key commodities from copper to metallurgical coal. If stimulus No. 1 sufficed to propel an incredible rally for the previously impaired stocks of commodity producers, I urge Fools to consider what a follow-up stimulus of more than twice its scale might achieve over its stated five-year timeframe. Don't let this become the most overlooked story of 2012! I'll look more closely at the implications of China's announcement for industrial commodities in a forthcoming article (bookmark this link), but for today I wish to highlight what I consider a remarkable opportunity to invest in precious metals in the wake of this week's selloff.

Alternate-reality checkDespite these myriad indicators that the global economy remains mired in a perpetual state of dysfunctional anemia -- and powerful reminders that systemic risk never went away -- gold and silver dropped like lead bricks Monday. Some relative strength lately from the U.S. dollar, alongside the indiscriminate selling of a mass dash for cash, have injured gold and silver prices and murdered the shares of miners that produce them. Fundamental considerations have, for the time being, flown out the window. That can continue for a while, but not forever.

And just as we witnessed in 2008 -- when precious-metal stocks were taken to the woodshed in advance of an unforgettable run to the upside -- I believe investors who have yet to seek some safe-haven exposure to gold and silver have received yet another invitation from the market to do so. I presented this ongoing correction as your last best chance to acquire gold when the selling first took hold back in August, and I encourage investors to view precious metals as increasingly primed to resume their bull-market run. As capital flows into the U.S. dollar and U.S. Treasury bonds, I want Fools to ask themselves whether those selections make fundamental sense as true safe-haven assets. Between gold and the greenback, I think it's clear which currency offers the ultimate safe haven.

Before we recap a few of the bullish factors poised to send gold and silver far higher, let's get a quick status report for the sector. Although sentiment toward gold has eroded noticeably in recent months, the SPDR Gold Trust (NYSE: GLD) remains 19% higher than where it started 2011, and 26% ahead of the SPDR S&P 500 ETF (NYSE: SPY) year to date. The Market Vectors Gold Miners ETF (NYSE: GDX) , meanwhile, has actually underperformed the S&P 500 (INDEX: ^GSPC) thus far, leading sharp hedge fund managers like David Einhorn to look to gold miners for tomorrow's monster outperformers. I have my eye on AuRico Gold (NYSE: AUQ) for a strong performance in 2012 as the Young-Davidson mine in Ontario enters production, while small-cap producer Primero Mining (NYSE: PPP) could just be the greatest gold stock in the world.

Silver climbed to a dramatic peak earlier in the year as a classic short-squeeze unfolded on the COMEX futures exchange, but amid the present correction the bullion proxy Sprott Physical Silver Trust (NYSE: PSLV) has slipped to a mere 3% gain year to date. Anticipating a very strong road ahead for silver once the indiscriminate selling subsides, I added Sprott's silver bullion proxy to my Motley Fool CAPS portfolio. The miners of silver have fared far worse, with the Global X Silver Miners ETF (NYSE: SIL) careening lower by nearly 20% so far in 2011. Among the battered universe of silver producers, I consider Silver Wheaton (NYSE: SLW) and Alexco Resource (AMEX: AXU) among the most attractive investment vehicles.

Tomorrow's inevitable realityGold and silver are headed much, much higher. Of this I am personally certain, and the task at hand for any prospective investor in the space is to determine his or her own degree of confidence in that outlook. I have studied the precious-metals markets exhaustively, from every angle, and concluded that continued impairment of the world's primary reserve currencies will unavoidably result in long-term increases in demand for gold and silver as the currency alternatives that are immune to such impairment.

No one knows precisely how the crisis in Europe will unfold, but it is crystal clear we have a bona fide financial emergency on our hands that will force governments and central banks to throw money they don't have at a problem they can't fix. There was a time when Europe thought it could erect a fence around Greece and contain the contagion, and the implied cost appeared within the bounds of reasonable intervention. But as that fence expands to draw a line around an entire continent, one shudders to contemplate the potential scale of interventions to come. Europe's EFSF, like the TARP here in the U.S., was more of a warm-up than a finale. While the dire scenarios coming into view in Europe are most unwelcome indeed, they are nonetheless bullish for gold and silver. Expanding sovereign debts and purposeful currency devaluation act like elevators to lift precious metals higher.

Zooming out further to take in the whole of the Western financial system, one is confronted with the interconnected nature of counterparty risk, which connects major U.S. financial institutions to Europe's fate like so much trans-Atlantic telephone cable. I believe that counterparty exposure helps to explain the Federal Reserve's move to require another round of stress tests. Legislative reforms, in my view, have badly missed the mark, permitting U.S. financial institutions to continue carrying derivative exposures at fanciful model-derived valuations rather than market-based reality. Aside from renewed systemic risk that could be triggered by Europe's woes, the U.S. economy remains vulnerable to contraction as a likely European recession unfolds. While many mistakenly view such a threat as bearish for gold and silver, that is an incorrect perspective. U.S. policymakers have already made it perfectly clear, both through substantial precedent and explicit promises, that additional quantitative easing and other interventions will come into play to combat any threat of contraction. The playbook has been etched in stone.

In a nutshell, I have concluded that the financial crisis of 2008, the accelerating emergency in Europe, and the unrelenting threats to sustainable economic recovery in the United States are all interconnected chapters of one giant global financial crisis. They are not, as commonly perceived, an amalgamation of unrelated events. Attempts to bury an unimaginably massive mountain of toxic leveraged assets beneath a veil of debt creation are, in my opinion, misguided and destined to fail. Because I have no confidence that this global crisis will be sustainably resolved through intervention, I place my confidence in the continued price appreciation of gold and silver. I am eager to see where you stand on the subject, so please share your thoughts and reactions in the comments section below.

Fool contributorChristopher Barkercan be foundblogging activelyand acting Foolishly within the CAPS community under the usernameTMFSinchiruna. Hetweets. He owns shares of Aurico Gold, Alexco Resource, Primero Mining, and Silver Wheaton. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has adisclosure policy.

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I think you will be surprised 12 months from now at your certainity of the bullish direction of gold & silver. If you look at the S&P 500 and compare to SLV they are almost identical and should continue to be so. I am just as certain that both willbe substantially lower by Dec 2012.

"Fool contributor Christopher Barker can be found blogging actively and acting Foolishly within the CAPS community under the username TMFSinchiruna. He tweets. He owns no shares in the companies mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy."

I thought you owned some of the precious metals companies listed above?

Gold and silver are "risk off" assets. They do not behave as such in the initial stages of a selloff because liquidations are indiscriminate and strategic (targeting pockets of preceding outperformance). As the precious metal bull market continues to mature, I maintain we will see gold and silver weakness of ever-shorter durations when crisis strikes investor sentiment broadly. like this. For now, U.S. Treasuries remain first in line for safe-haven seekers, resulting in the strong USD rally, and yes, that weighs on gold and silver as priced in USD.

After the initial selloff, when capital grows more thoughtfully defensive in place of this knee-jerk flight to cash and Treasuries, I think you'll find gold and silver will get a strong bid. They are the more logical safe haven play. The miners are so undervalued that I am happy to wait out the looming bottom to this correction for the powerful upside awaiting on the other side.

Everyone knows the game is fixed, but "it is the only game in town ...."

Who plays that game? Only a fool (small f)

Saint-seducing gold has held many in its thrall, and right now it holds millions of individual investors. Most of them have all kinds of mathematical models to show what gold is "worth" - my personal-least-favorites being gold ratios, such as gold: dow, gold: oil, gold: eggs, whatever.

It is all nonsense. Humans are pattern finders, and we bestow patterns with significance and causes that are not necessarily there.

The simple fact (that will be obvious with hindsight) is that:

your gold is only worth what someone else is prepared to pay you for your gold

And, like individuals holding almost every asset, people like to buy when prices are trending upwards. Prices edge up slowly, in steps, over years.

But if the ONLY value-added comes from capital appreciation (i.e. no income, or dividends of any kind, no underlying profits, or growth) then the price of that asset will, sure as night follows day, plummet at some point.

Personally, we put in a large backyard garden this past summer. Planning more next year. Also, improvements to the house have cut our heat bill by 50% over the last five years. With what was saved from these and some other things, we've been investing in the market, including some SLW when it was lower. $19 cost basis. However, if any other good "reality" investments show up, that will be the first priority for cash.

Very well said! Congratulations on your backyard garden, and your impressive energy savings! Aside from improving a household's finances considerably, it just feels great grow increasingly self-sufficient and shrink one's footprint all at the same time.

"your gold is only worth what someone else is prepared to pay you for your gold"

I just wanted to reiterate what Decbutt stated earlier, because it is spot on.

I'm not prepared to believe that gold is the sound investment that people have been claiming. While I admit that the legislative response to the situation has been underwhelming at best (and will continue to be, so long as we have all of one party and half of another held completely in thrall to the 1% stakeholders), I find it telling that China's massive stimulus measures - and commensurately strong economy - are making such a difference. There is nothing but political will preventing similar measures in the United States, which is much richer than China in essentially every measure. And of course, the parallel here is World War II - much higher deficit spending, stimulating much higher growth, paying off a much higher total debt level relative to GDP.

Will it be possible to make money off the appreciation of gold and silver? Sure. But I'm not one for trying to time the market, and if things get so bad that gold is the only financial refuge left, then things will likely have gotten so bad that you'll be better off investing in food and guns.